By Elmer L. (Al) Meszaros, CFA, Partner

As the markets continue their slow but steady recovery from the bear market of 2001-2002, many financial journalists are suggesting that investors “diversify” their investment portfolios in order to enhance the opportunity for growth, while reducing investment risk. Their “recommendations” include creating a portfolio comprised of growth, technology, and international stocks, various bonds, and real estate investment trusts (REIT’s). Diversification is healthy and necessary. But, we also know that over-diversification (or the “eggs in a thousand baskets” approach) is actually detrimental to performance and doesn’t really protect against downside risk.

No protection

Over-diversification did not protect investors from 2001-2002 when nearly all stock categories declined. Only bonds and cash registered positive returns. International stocks, which are often suggested for diversification, were down 25.3% during that period alone. Market risk, or what the academics call “systemic risk” cannot be diversified away by buying even more stocks. A few years ago, we met someone who owned 140 different mutual funds. It was the worst case of over-diversification we had ever seen!

Settling for mediocrity?

The mathematics of large numbers of stocks drives toward mediocre performance. For example, studies indicate that a portfolio with only 15 stocks has a 1-in-4 chance of outperforming its benchmark, while a portfolio of 250 stocks has only a 1-in-50 chance of outperforming its benchmark. Studies have also shown that a portfolio of 30 stocks can achieve 95% of needed diversification. The volatility may be greater with a focused portfolio, but so are the rewards.

Two types of risk

The purpose of diversification is to reduce two types of risk: volatility and permanent loss of capital. The antidote to volatility is the virtue of patience, or a longer time horizon. If we buy Pepsico stock for our client portfolios today and know that we have to sell it next week, that’s a very risky transaction. However, a 10-year time horizon makes it virtually a very low risk transaction.

Reducing risk

At Midwest Investment Management, we address volatility through our “Strategic Value” style of investment management. Countless studies have demonstrated that the “Value” style is less volatile and more rewarding than other categories. For example, over the past 21 years the Russell Large Value Index grew an average annual rate of 14.2%—the best of all the major categories, with less volatility. It was down only 4 years in 21, the fewest declines among stock categories. In its worse year, 2002, the Large Value index declined 15.5%, far less than the worst year for the S&P 500, which was down 22%, and the Large Growth Index, which was down 28%.

Reducing permanent loss

We address the risk of permanent loss of capital (a more serious risk than volatility) through two simple rules of sound investing: 1. Buy a stock only when the price drops 20% to 30% below its intrinsic or fair value. 2. Buy only quality companies that can increase profits 8% to 12% each year. This means a company must occupy a strong enough franchise-like position to generate above-average profitability, and thus free cash flow to pay rising dividends and reinvest for growth. I am pleased to note that half of the companies we have purchased for our clients’ portfolios increased dividends in each of the past 10 years—a rare achievement.

History of over-diversification

claim that if markets are efficient, (i.e., if current prices reflect all relevant information), then new information rules the future—which is unpredictable. Thus, the markets are a “random walk,” and investors should buy indexes in all asset classes to reduce risk. At Midwest Investment Management, we see two flaws with the “efficient market” hypothesis. First, just because stock prices are sometimes efficient doesn’t mean they are always efficient— that’s a big difference! For example: were stock prices “efficient” on the morning of October 19, 1987 (the day the market crashed) or six hours later when the market declined 23%? Secondly, there are a group of investors who have beat the indexes consistently. Warren Buffet calls them the “super investors of Graham & Doddsville.” They follow a simple directive, which is to “buy below intrinsic value”—a key strategy we employ on behalf of our clients.

For decades, Al Meszaros’ skilled stock-selection process has produced outstanding returns for his clients. To learn more about the advantages a managed portfolio offers, you are invited to contact him at (216) 830-1133 or elm@mimllc.com.